Review: objectives Remind you of the main theories. Overview of how parts of the course all fit together. Draw the most important and general lessons to remember from the course. CHAPTER 2 The Data of Macroeconomics slide 0
Macroeconomic model with Three Markets & Three agents work Labor Market hiring Financial Market saving borrowing borrowing Households Government Firms consumption government spending Goods Market production investment CHAPTER 2 The Data of Macroeconomics slide 1
Building blocks of theories Production: depends on factors capital and labor s Y F ( K, L) Demand for goods comes from C + I + G Consumption behavior: responds to current income by a MPC: C C by Fisher model suggests should include future income and the interest rate also. CHAPTER 2 The Data of Macroeconomics slide 2
Building blocks continued Investment behavior: responds to the interest rate I I dy Money demand behavior: responds to both the interest rate and income, as well as proportional to price level. M ey fr P These building blocks summarize our assumptions about hoe people behavior, and can be combined in different ways. CHAPTER 2 The Data of Macroeconomics slide 3
Equilibrium in the Long Run Key assumption: Prices are flexible to clear markets (Supply=demand) This is assumed by the Neoclassical model. Equilibrium condition: or equivalently: So And Y Y F ( K, L) Y CY ( ) I( r) G s Y C I G S I the interest rate adjusts to make investment equal available saving in the economy. CHAPTER 2 The Data of Macroeconomics slide 4
Equilibrium in the Long Run Big Lesson #1: In the long run, the level of GDP is determined by the supply side of economy (available factors and technology). CHAPTER 2 The Data of Macroeconomics slide 5
Equilibrium in the Long Run Nominal side of the economy: Money supply set by central bank: s M M Equilibrium in money market: M ey fr P Since Y and r are already determined, the money market determines the price level. So a rise in M s will raise P (inflation) s proportionately. P M ey f r CHAPTER 2 The Data of Macroeconomics slide 6
Equilibrium in the Long Run Big Lesson #2: Classical Dichotomy In the long run, a change in money supply only affects nominal variables (like price level and inflation), without affecting real variables (like GDP or unemployment). CHAPTER 2 The Data of Macroeconomics slide 7
Equilibrium in the Short Run Key assumption: Prices are fixed, so markets do not clear (Supply demand) use P P not Y Y F ( K, L) This is assumed by the Keynesian model Goods market equilibrium: production adjusts to planned expenditure: Y C I G C by I dr G CHAPTER 2 The Data of Macroeconomics slide 8
Equilibrium in the Short Run Y C I G C by I dr G This is an IS curve: 1 Y 1 C I G dr b Which says output and interest rate can be affected by changes in fiscal policy like G. CHAPTER 2 The Data of Macroeconomics slide 9
Equilibrium in the Short Run Money market: With r and Y now free, the money equilibrium becomes an LM curve: s M ey fr P 1 s e M r Y f f P Which says output and interest rate can be affected by changes in money supply. CHAPTER 2 The Data of Macroeconomics slide 10
Equilibrium in the Short Run Big Lesson #3: In the short run, changes in demand side of economy affects amount of goods produced Big lesson #4: Break Classical Dichotomy: In short run, a rise in money supply does affect the level of GDP and other real variables. CHAPTER 2 The Data of Macroeconomics slide 11
The SR and LR effects of an IS shock A rise in G shifts the IS curve right raising output and the interest rate in the short run. In the long run, the price level rises which shifts the LM curve left Until output returns to its normal level. r P P 2 P 1 LRAS LM(P 2 ) 3 LM(P 1 ) 2 1 IS 1 IS 2 Y Y LRAS 3 1 Y 2 SRAS AD 2 AD 1 Y CHAPTER 2 The Data of Macroeconomics slide 12
The SR and LR effects of an LM shock r P P 1 LRAS A rise in M shifts the LM curve right 13, Lowering the interest rate and raising output in the short run. In the long run, the price level rises shifting the LM back to its original position Until output returns to its normal level. P 2 LRAS SRAS AD 2 AD 1 Y CHAPTER 2 The Data of Macroeconomics slide 13 Y Y 3 1 LM(M 1 /P 1 ) =LM(M 2 /P 2 ) 2 LM(M 2/P 1 ) 2 IS 2 Y
Other things to know: A Phillips curve describes the tradeoff policy makers can choose, between reductions in unemployment and inflation. e u u n So if monetary or fiscal policy is used to raise output and reduce unemployment, this typically comes at the cost of extra inflation. CHAPTER 2 The Data of Macroeconomics slide 14
Main ideas from Solow Growth Model The steady state condition (where a country ends up in the long run) depends on its saving rate, population growth rate, and technological progress: s f(k) = ( +n +g)k The golden rule condition (where consumption per person is highest) is also determined by these same things: MPK = + n + g Getting to the golden rule requires the right saving rate and good policies. CHAPTER 2 The Data of Macroeconomics slide 15
Factors market In a well-functioning factors market, the rate of payment is determined by the marginal productivity: labor: capital: real wage MPL real rental rate MPK Natural rate of unemployment comes from: Structural causes: wage rigidity, unions Frictional causes: sectoral shocks, unemployment insurance CHAPTER 2 The Data of Macroeconomics slide 16
More on Consumption Theory Fisher s theory of intertemporal choice Consumer chooses current & future consumption to maximize lifetime satisfaction subject to an intertemporal budget constraint. Shows that current consumption depends on lifetime income (including both current and future income), as well as the interest rate. This theory helps explain the Consumption Puzzle : why a temporary rise in income leads to a drop in average propensity to consume (APC), but a permanent rise in income leaves APC constant. CHAPTER 2 The Data of Macroeconomics slide 17